Voices
Bank Regulators Have Ethical Problems of Their Own

Some refer to the latest and greatest financial crisis as a "perfect storm." This metaphor both highlights the severity of the crisis and attributes it to a rare, unlikely combination of forces that happened to combust simultaneously.

The "perfect storm" image can be a convenient way to deflect blame from humans, leaving the impression that external, natural forces were responsible for the crisis. Then the Federal Reserve, a bastion and defender of financial market stability, arrived to save the day  or at least, to keep us as safe and dry as possible.

But there is another way to view the crisis. Our central bank may have been seeding the clouds before the storm. And the Fed's forecasts never saw the downpour coming.

Two recent speeches on banking ethics given by Federal Reserve officials suggest that the more cynical view may be appropriate.

On Jan. 20, Thomas Baxter, general counsel at the Federal Reserve Bank of New York, gave a talk at the Bank of England titled "The Rewards of an Ethical Culture." The same day, Federal Reserve governor Jerome Powell gave a speech on the Bank of England's "fair and effective markets" initiative. Both officials noted the public's loss of trust in financial markets in recent years, which they said was rooted in concern about the behavior of market participants.

Baxter certainly sounded alarmed. "At the New York Fed, we have made ethical culture a priority for financial services," he said. "Bad behavior in the financial services industry prompted the New York Fed's call for a stronger ethical culture in banking."

This speech lays bare a problem with the Fed's approach to ethics. The New York Fed has made ethical culture a priority  but for "financial services." The implication is that bad behavior arises solely in the markets. The Fed has arrived to manage the situation to further the public good.

But what about the Fed's own behavior?

Baxter is silent on this point. He makes no reference to ethical challenges within the Fed, nor to the Fed's efforts to clean up and improve own ethical culture.

Powell's speech raises similar issues. He refers to efforts to restore public confidence in financial markets after "depressingly numerous instances of serious misconduct in these markets in recent years."

"Proper market functioning is really a public good that relies on confidence and trust among market participants and the public," he continued. "Bad conduct, weak internal firm governance, misaligned incentives, and flawed market structure can all place this trust at risk."

The impression Powell gives here is that market failures, including "bad behavior," have social consequences. Regulators like the Fed exist to curb bad behavior and protect the public.

There are more than a few good eggs out there in those evil markets. But if bad banks capture bad regulators, and if those regulators are charged with overseeing banking ethics, we're left with a dire situation.

Boston College finance professor Edward Kane has developed some good ideas for improving the ethical culture among bank regulators. Kane has argued for the development of accounting standards that better reflect the transfer of wealth from taxpayers to financial firms arising from implicit subsidies. He has called for the establishment of a specialized training program for regulators that would stress proper conduct  for example, not selling out to regulated firms. And he has developed ideas for incorporating forfeitable deferred compensation into regulators' pay packages as a way to help align the incentives of regulators with the welfare of the public they serve.

Like Baxter and Powell, Kane expresses concern about ethics in financial markets. But Kane's emphasis is on ethics in markets as they are regulated  with regulatory ethics a source of his concern. In text for an upcoming presentation that Kane is scheduled to give to the Joint Committee of Inquiry into the Banking Crisis in Ireland, he states:

In my view, aided and abetted by deferential regulators, U.S., Irish, and other European bankers have committed crimes on the public that deserve to be characterized as theft by safety net. The victims are current and future citizens.

The time has come for leaders to emphasize ethics within the Federal Reserve and other banking and financial regulators as a step toward rebuilding trust in our financial markets. A Fed that is willing to examine its own shortcomings and genuinely strive to improve its own ethical culture can help set an example for the market as a whole  and help keep us from repeating the disasters of the past.

Bill Bergman is director of research for Truth in Accounting and teaches finance and economics at Loyola University Chicago. He previously served as an economist and policy analyst at the Federal Reserve Bank of Chicago.